Tuesday, June 21, 2011

Some musings on Europe

This post is, even more than most blog posts, a collection of speculative musings.  I'm putting it out there in the hope that people will make arguments or point me to links that will either refute or confirm what I'm suggesting or at least sharpen up my thinking.

The gist of this is that I'm having trouble with the idea that there is a serious global risk from the situation with the PIG countries (I'll leave Spain out of it for now, since there are signs of Spain beginning to recover).  The three worst off countries have their nominal GDP above (source), and at least Ireland and Greece are still shrinking in economic terms as of the last available data.

For the sake of discussion, I'd like to posit that these countries cannot pay back their debts, that the current austerity measures in an attempt to do so are causing ongoing economic contraction, that this will not be politically sustainable, and that, either sooner or later, these countries will default.

The other possibilities are that austerity minded governments somehow manage to hold on to power long enough to eventually pull the economy through the contraction phase, or that the rest of Europe decides to stop treating this as a liquidity issue and out-and-out give money to the affected countries to stimulate their economies.  I'm not certain these cases are impossible but let's posit that they don't happen and that two or three of these countries default, and possibly exit the euro-zone as a result.  This is in a spirit of analyzing the worst reasonable case.

So there's little question that a default will cause considerable further degree of economic pain in the affected countries.  However, I'm not persuaded that there is a case for all that much contagion.  In terms of direct effects, these economies are small:

Even if they were to contract in half, it's not that large on the scale of the whole Eurozone, and the trade effects on the rest of the Eurozone will be smaller than the contraction of these economies themselves.

Then in terms of the balance sheet/financial contagion: at the moment, I can't find evidence that the exposure is large enough.  The other day, commenter John pointed to this Guardian post with data from UBS about bank exposure to sovereign Greek debt:

Look at the "% of equity" column.  Banks over 100% will be insolvent if Greece defaults.  The upshot is that there are no banks outside of Greece that are going to go under if Greece defaults, even if it does so 100% (which is unlikely).  There are banks that will be hurt and may have to raise capital, but none that will be insolvent or unable to operate.  And presumably, the banks exposed to Greece are by and large not the same ones exposed to Ireland.

In other words, if Greece and Ireland go down in flames, exit the Eurozone, turn into Argentina, whatever, I don't see how it causes more than a mild recession, if that, in France, Germany, etc. Still less the United States.



James said...

I think the danger of contagion comes from bank runs.

Lets say that Greece goes the way of Argentina, finally capitulates, and decides to withdraw from the EMU. The first thing they have to do is impose a Corralito.

This is devastating for a society. Imagine waking up one morning and finding that you have 1/3rd the savings that you had when you went to bed the night before.

So the Irish and the Portuguese will see this and rush to their banks to withdraw their savings so they can put them someplace safe. That will leave the governments of Ireland and Portugal no option but to impose Corralitos of their own. Then Spain will undoubtedly be the next domino. (I believe Spain is in worse shape then is generally recognized - Spain had a housing bubble every bit as big as the US but has the Spanish banks have been essentially hiding the problem by not foreclosing on delinquent borrowers.)

After Spain has imposed its Corralito, then the banks runs will begin in earnest in Italy.

Notice how as each domino falls the EU has less leverage (i.e. liquidity and capitalization) to try to deal with the situation. Spain and Italy together comprise something like 40% of the GDP of the Eurozone.

The Germans are worried about being the last ones left at the table such that they will have to pay "the bill" all by themselves. This points to the additional problem that as the situation worsens there will be greater incentives for the rich countries to abandon the EMU so they don't have to pay their increasingly large share of "the bill". My understanding is that currently the ECB and the Bundesbank between them have something like one trillion dollars of PiiG paper on their books (links below) - if the PiiGs default then the remaining EMU members will have to recapitalize these central banks and the cost will be enormous.


Frugal said...

I think it will be tough for the economies of these countries to grow after they default. Since pre-default gowth was heavily dependent on borrowing money and very little borrowed money will be available after a default, growth will not happen for a long time after a default.

Blue Peter said...

If you had done a similar analysis for Lehmann just before that went pop and everything seized up, would you have come to a similar conclusion? And I presume that Greece is biggers than Lehmann's?


Frozen in the North said...

Your analysis on Portugal / ireland/ Greece is correct, all three are very small economies of limited consequence, together they add up to 7% of Europe's overall GDP (and that may be inflated). The issue are the other at risk players: Italy, Belgium and Spain (and at some level France), all have very high levels of debt, surprisingly similar to what is being seen in Spain (which is still manageable). The fear that the over leveraged banks would be at risk now seems to have dissipated, since they all sold their Greek exposure to the ECB at par! My suspicious was always that the ECB's action was to allow the European banks to unload their Greek, Portuguese and Irish exposure.

Contagion in this context will come from the "next" weak animal in the heard. Belgium has been operating for over a hear without a government!

Burk said...

The comments above have been very good. Additionally, there is an ideological component, where the top end of town is horrified at having to take ANY responsibility (haircuts) for their own reckless lending. The ECB and governments (and IMF, oddly enough) have been kind enough so far to bail them out via loans to the debtors, especially Greece, though on punitive, and as you say ultimately self-defeating, terms.

The ECB prints the money, so they could go on bailing out indefinitely. Any inflation risk is truly far away, though the Europeans don't seem to realize that. On top of their fears is the political horror of giving money to the south end of town (south park, one might say!).

They really have a fundamental failure to face up to what integration means, and to grapple with the basic dynamics. The creditors need to take some losses, the central bank needs to do real integrated policy, and the EU government needs to add fiscal policy towards growth rather than austerity.

But it looks like they will never get there, which leads to all the fears of bank runs and economic/political disintegration noted by the above commenters.

Incidentally, the Corralito doesn't have to be so painful. Greece would default on its government euro debt, issue new drachmas, and set a devalued exchange rate, which would go rapidly to market rates. It could immediately honor all euros inside Greece even if the EBC refused to honor them anymore. At any rate, Argentina ended up with robust growth rates including international credit and much lower unemployment, within a year or two.

Seani said...

Read this, and all the background support material to understand why they are worried. Basically the banks are insolvent and can't handle a default on bonds.


Probably the best thing for Greece to do would be to drop the euro and default 100% on its debts and nationalize its banks.

Once one country does it others will follow (ireland, portugal, spain, italy) and probably then everyone goes back to their own currencies.

I'm assuming that the ECB doesn't want this, so they will use every trick in the book to keep the dream alive.

If I had significant euros in a european bank, I would be in line right now to withdraw it. The great part of withdrawing cash before a potential crisis is that you can always put it back in later, but if there actually is a crisis, and everyone gets there before you, there will be no money left for you.

kjmclark said...

I think the whole discussion is a really interesting side note, but not a risk to civilization. At most it results in the EMU countries going back to their old currencies and a Eurozone recession. It might have knock-on effects in North America and Asia, but like our financial crisis, it won't bring down their economies.

It would bring down diesel consumption a bit. I suppose that's interesting, but I doubt it would amount to that much.

Have you looked at the whole solar flare/Carrington event concept? Now *that* could be a serious issue, though it's a seriously low probability event. (Cool solar flare two weeks ago not withstanding.) Of course, Katrina and the Tohoku earthquake were also very low probability.

I suppose if EMU dissolving led to some kind of armed conflict that might be something, but these are pretty domesticated democracies. Hard to imagine a WWIII out of that.

James said...

@Burk - I can't see how the Corralito can possibly avoid being so painful. If Greece abandons the Euro and issues new Drachmas and permits the Drachma to float - it will get a devalued exchange rate (probably coming to rest at 3 drachmas=1 euro if history is any guide).

But as part of this they would have to pass a law that at the time of the switchover, all savings and debt are converted at a rate of 1 euro for 1 drachma ... and thus everyone with Euro savings in Greece is going to take a big hit. It is impossible for Greece to get a devalued currency without holders of that currency losing out.

Of course net debtors can do very well from currency crises if they have used the borrowed money to buy assets which hold their value through the currency crash.

In support of my assertion above that the Spanish housing bubble has a lot more deflating to do (and thus that Spanish banks are less solvent than they are pretending to be), see this handy dandy housing bubble comparison graph courtesy of The Economist:

I suggest you leave the series set to "House-price index", set the start to "1990 Q1", set the End to "2010 Q1", and then select two country selections - Spain and US(Case Shiller). Granted the data is not entirely up to date but I think it gives one a sense of the scale of the balance sheet problems that the Spanish banks are facing.

BOP said...


This may be of interest -


Burk said...

Hi, James- No question that the switch would be a mess. But the whole point of the switch is the gain the ability to devalue (and regain the ability to run independent fiscal/monetary policy).

So yes, those who gauge their value vs the rest of Europe (i.e. Germany) will be in pain. Fewer vacations to Berlin, and more vacationers from Berlin. But internally, Greece can sail on without holding savings hostage, etc., and with a much improved export position.

Greg said...

Further to kjmclark's observation that "the whole discussion is a really interesting side note", I think the Euro situation sheds light on the larger issues we face.

I have in mind Shell Oil's scenarios for future energy developments, "Scramble" and "Blueprints" -- or, more accurately, the names of these two scenarios. "Scramble" -- every country for itself -- and "Blueprints" -- coordinated planning -- are at opposite ends of the spectrum of possible responses to the coming geopolitical, socioeconomic, and environmental crunches.

Europe has every incentive to follow the "Blueprints" route with this little issue -- after several continent-wide wars culminating in two "total wars", no-one knows better than Europe what happens under a free-for-all. And the Europeans are best placed to be able to work together, for they are all relatively wealthy and packed closely together. Europe has the best incentives and the best opportunity to follow the "Blueprints" path.

If Europe, even Europe, can't resolve this relatively minor crisis in an orderly, equitable way, then the odds of "scramble" being the response to everything just got considerably higher. That's a risk to civilization.

Alexander Ac said...


what are the signs of "spanish recovery" - any link to that?

Here are bond yields, if they increase a bit, spain goes greece at al I think....

Stuart Staniford said...

There's an interesting piece on this question in the NYT here. The gist of it is that no-one can or will say whether derivatives contracts worsen the problem a whole bunch. That's adding a cloud of uncertainty.

Burk said...

Krugman, on the Corralito: not so bad!